Capital structure practice solution(1)

# What actions the company may take in financial

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What actions the company may take in financial distress that will put your loan money in risk? What actions will you take to prevent these destructive behaviors?

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4. Your company currently has \$200 million debt and \$800 million equity. Several bond covenants prevent you from retiring the existing debt and limit the maximum debt ratio to 40%. To maximize firm value, you are considering choosing the optimal capital structure from three possible debt ratios, 20%, 30%, or 40%. Since the company has invested in all positive NPV projects, you do not want to change the amount of total assets. Therefore, if you decide to borrow more debt, the proceeds will be used to buy back stock. The interest rate of all debt is tied to credit rating (see Exhibit 1). The credit rating is determined by EBIT coverage ratio (see Exhibit 2). Your company is expected to maintain EBIT of \$80 million. Your current rating is AAA, which corresponds to an interest rate of 4.3%. Current stock beta (levered beta) is 1.5. The risk free rate is 4% and the market risk premium is 5%. You company faces a marginal tax rate of 30%. Exhibit 2 Exhibit 2 Rating Default Spread If EBIT Cov> EBIT Cov ≤ to Rating is AAA 30 8.50 100000 AAA AA 50 6.5 8.5 AA A+ 63 5.5 6.5 A+ A 71 4.5 5.5 A A- 84 3 4.5 A- BBB 117 2.5 3 BBB BB+ 190 2.25 2.5 BB+ BB 265 2 2.25 BB B+ 330 1.75 2 B+ B 395 1.5 1.75 B B- 720 1.25 1.5 B- CCC 1375 0.8 1.25 CCC CC 1600 0.65 0.8 CC C 1800 0.2 0.65 C D 2000 -100000 0.2 D Default spread in basis points (100 basis points = 1%)
a) If you increase your debt ratio to 30%, what will be the EBIT coverage ratio, Credit rating, and interest rate? (Hint: Compute the EBIT coverage ratio using the

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